Why do countries run trade deficits?

A country could run a trade deficit for two reasons:

- its firms are not competitive internationally and cannot export their goods and services
- the country is very attractive to foreign investors

In the first case, firms may not be using the latest know-how or the currency of the country could be overvalued (i.e. too expensive) making the domestic products too expensive. The solution is to either improve the productivity of the firms or/and to depreciate the currency.

The second scenario is less well understood. Think of the U.S. before the 2008 financial crisis. The U.S. economy was booming along with its property prices and the stock market. The attractive investment opportunities drew large volumes of international capital from other countries. Foreigners gave credit to the U.S. government and its financial institutions that, in turn, financed the U.S. firms and households. The financing was used to buy goods and services, many of them imported. As a result U.S. imports increased substantially and the trade deficit expanded. It was driven by foreign investment entering the U.S., mostly from China and Japan.

In that case, there is no need to do anything. When the U.S. economy slows down, consumption declines and the trade deficit closes down. See how the growth of U.S. imports correlates with U.S. economic growth.

In principle, trade deficits could also arise if other countries restrict our exports with tariffs and other restrictions or keep their currencies artificially undervalued (i.e. too cheap). Such policies may call for retaliation with tariff restrictions on their exports and pressure to let currencies adjust to market conditions. However, countries ultimately don't benefit from these trade restrictions as they slow down trade and development. Therefore organizations such as the World Trade Organization have been established to reduce trade restrictions across countries and to monitor for unfair trade practices.


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